[This post was first published in the Fairfax NZ Sunday Star Times on 27 July 2014 with the title ‘The power of two in China’.]

Fonterra’s recent announcement that it will partner with the multinational Abbott in the development of its next hub of China dairy farms is significant on two counts. It affirms Fonterra’s previously announced intentions to press ahead with further farm hubs in China now that the second hub in Shanxi Province is under way. That means that Fonterra retains its confidence about long term prospects in China. The announcement also means that Fonterra has found a top notch partner for some of its China operations.

Fonterra is already a supplier to Abbott of base powder ingredients for its Asian infant formula factories, but the new co-investment in China heralds a much closer relationship. On the surface it looks like an ideal match.

Fonterra’s expertise lies in producing high quality milk and in the first stage processing thereof. Abbott’s expertise lies in value-added nutritional products and marketing these to health conscious consumers.

Currently, Abbott does not have a secure source of milk product from within China but has everything else that it needs. Without an integrated and tightly linked value chain from the cow to the high end nutritional products, Abbott will struggle in the new Chinese regulatory environment. So partnering with Fonterra in the cow to milk part of the business solves that problem nicely.

In a perfect world, Fonterra would not need Abbott and would take its own products to market. But it is not a perfect world. Fonterra has neither the capital nor the depth of consumer marketing expertise to compete in the specialty products where Abbott has built its reputation.

Abbott is not particularly well known in New Zealand, but it is a huge American-based health care company. By any measure – be that number of employees, revenue or profits – it dwarfs Fonterra. About one third of its revenues come from nutritional products. The rest comes from medical diagnostic tests and medical devices. It also used to be a major pharmaceutical company but that was spun off at the start of 2013 into a separate company called AbbVie.

Abbott’s two best known nutritional brands are Similac and Ensure. The Similac products place Abbott as No1 in the USA for infant formula. Globally, they claim to be No 2. The Ensure range of nutritional drinks places Abbott as No 1 globally for adult nutrition drinks. There is a strong focus on healthy aging.

Abbott’s forward looking strategy is to place high emphasis on developing countries, with China at the top of the list. Currently, their share of the infant formula market is only about 4%, which places them behind Nestle, Mead Johnson and Danone (which operates as Nutricia in New Zealand). Abbott may well decide to place most of its energies in China on the ‘healthy aging’ market where competition is less intense and new opportunities are greater.

The specifics of the Fonterra-Abbott joint venture have not been made public. But Abbott has stated that the arrangement developed following discussions with Fonterra about the damage to Abbott from the Fonterra botulism scare. Whereas the giant French-based Danone is still fighting Fonterra for compensation, Abbott and Fonterra have managed to move on.

An early task will be to decide on the farm location. This could be challenging, as most towns and counties do not want a big feedlot operation nearby. It seems likely that each company will invest 50% of the required $NZ320 million. Presumably Fonterra will then take a management contract to run the 16,000 cow operation. Abbott will then presumably have delivery rights to the milk.

Although Fonterra’s existing dairy farms in China are to date proving very successful, there will be plenty of challenges as they scale things up. The biggest challenge may well be getting suitable managerial staff. And as with most large scale companies, it is the strength of organisational culture that so often determines success or failure.

The Fonterra farming systems in China are essentially clones of the mega American farms based on ‘cut and carry’ feed systems, total mixed rations, and housed cows. These systems are not taught in any depth within our New Zealand agricultural science programs and the differences are indeed profound. Combine this with the language issues, and it is going to be a real challenge for any Kiwis working there. Of course, the long term solution is for Chinese nationals to fill the operational management roles, but this will require lots of training.

Fonterra will also need to find further partners if it is to achieve its goal of 1 billion litres per annum by 2020. Once this third hub is complete, then Fonterra will still only be half way to that goal. Even ignoring the expected growth in market demand in the coming years, this would still give Fonterra only 2% share of the Chinese milk market.

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About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.